How blending fundamental company insights with quantitative metrics can add depth to the expected return inputs for portfolio optimizations.

In the face of the 2020 pandemic, large companies with strong balance sheets generally outperformed; however, the positive vaccine news in November caused small caps to post their best monthly performance in decades, edging out large caps on a year-to-date basis, as of December 17. As a result, small caps are currently trading at a notable premium to their large cap counterparts, with the Russell 2000 Index trading at a next-twelve-month P/E of approximately 32 compared to 22 for the S&P 500. That premium is nearly two standard deviations above the average for the last 10 years.

Determining the intrinsic value of a company can be difficult, especially with multiples as high as they are currently, and especially in the world of small caps, where businesses may be less understood, stocks may have less analyst coverage and markets can be more volatile.

To find and capture attractive value opportunities in the small cap world, we think investors need to take an innovative approach that uses all the tools we have at our disposal.

Deeper Understanding

The combined quantitative and fundamental resources of an asset manager such as Neuberger Berman offer opportunities too collaborate on this challenge. To this end, we look to incorporate fundamental insights into our systematic processes in an effort to build better investment portfolios. Typically, quants use fundamental and technical metrics, together with risk estimates, to generate expected returns across a broad range of stocks which can then be used for portfolio optimization. Diversification is a key risk management tool for quant portfolios, as it allows bets to be spread across a wide number of names—often 200 or more—in order to capture different themes and factors while minimizing idiosyncratic stock risk.

By contrast, fundamental portfolios are often more concentrated, holding 50-100 names or even fewer. Because they focus on a much smaller number of stocks, however, fundamental analysts have more information, and arguably a deeper understanding, of each company. That means that we, as quants, potentially have access to additional information for those 50-100 names.

This level of detail—which draws on a range of information and techniques, from normalized financials and customized discounted cash flow analyses to peer comparisons and discussions with company management— would be difficult to scale across an entire universe of thousands of small cap stocks. However, for select stocks, all of that information is captured in a single quantitative metric, in the form of the analyst’s price target for each security. These price targets therefore reflect an understanding of company-specific operations and future growth drivers, and we are able to convert them to expected returns estimates. We can then use these expected returns to supplement quant-only forecasts and create an “integrated expected return” for each stock to use in our optimization framework.

Now that we have updated expected returns, we can focus on portfolio optimization in order to manage tracking risk, balance sector exposures and maximize alpha potential while considering each position’s marginal contribution to active risk.

We believe the resulting portfolio benefits from the depth and detail of the fundamental sector experts’ understanding of underlying business dynamics, as well as the breadth and discipline of cross-sectional quantitative analysis. Integrating these complementary forms of analysis by tapping into the fundamental expertise of our colleagues within a systematic framework, allows us to increase our conviction in positions by incorporating more value-add information into the portfolio construction process. We find this particularly useful in the world of small caps, and we think this source of greater conviction will be especially helpful at a time when valuations are full or stretched.